Turning of the credit cycle

Not long ago, the Indian economy was on a song. Corporate confidence was high and balance sheets appeared strong. But with rising inflation, interest rates started moving up. Companies were hit by rising cost of funds and a weakening business environment. The sudden depreciation of the rupee also led to uncertainty and debt obligations grew substantially. The result was a deterioration of credit quality and banks were left with increasing non-performing assets (NPAs).

Though a slowing economy leads to widespread credit distress with smaller companies being easy prey, the bulk of the NPAs can now be attributed to a handful of sectors such as infrastructure, power, airlines, and some others. Inordinate delays in regulatory clearances have left projects worth trillions in a limbo. Coal and gas shortage made the situation worse. A sustained onslaught of high inflation has weakened consumer finances and sentiment, which has affected real estate projects. Many are stuck with high inventory and this sector looks set for some more pain in the short term.

As usually happens, rising NPAs put the banks, especially the public sector ones, on the defensive and they inevitably start tightening their fists. After all, isn’t putting money in government securities at 9% safer than lending it in a weak economic scenario and worrying about NPAs? This negative feedback loop further affects the economic recovery by choking credit.

Remedial measures

The alarming rise in NPAs needs some strong medicine so that banks’ health is not jeopardized and the credit needs of the economy paralyzed. The Reserve Bank of India (RBI) and the finance minister have fired their salvos by emphasising the importance of recognizing permanently impaired assets expeditiously and clearly differentiating them from assets which are temporarily challenged. This stance is very healthy for the banking system and the economy in the longer term as such assets lock up capital that can be put to much better use. It will also significantly free up lenders’ and bond investors’ bandwidth. Also welcome is RBI stressing on promoters making their share of sacrifice (in Western markets, promoters are the first to lose their skin).

The situation of stressed and distressed assets can be further improved by improving recovery mechanisms and by allowing or even encouraging healthier companies to take over these assets.

Things are looking up slowly

At the macro level, credit quality is improving as shown by trends in rating upgrades and downgrades of the rating agencies. We have also seen Indian companies deleveraging by selling off assets and raising equity; to quote few examples Tata Power sold its interest in the Indonesian coal mine, DLF sold its stake in Aman Resorts and Bharti Airtel raised equity to reduce debt. Jaiprakash Associates sold their entire holding in the Bokaro cement unit for the same purpose and Tata Steel sold their Thane land parcel. Apart from that, many companies in the infrastructure sector with very high leverage are also considering selling assets or stakes in subsidiaries to improve their debt-servicing ability. We view this debt-consciousness positively.

However, the credit situation is not out of the woods yet as can clearly be seen by the high number of corporate debt restructuring referrals and also the continuing stress evident in the results of banks and finance companies. Liquidity continues to be tight, what with the largest source of finance, the state-run banks still conserving capital. The situation today is, however, much better than what it was a couple of months back. Exchange rate has stabilized, inflation has been on a downward trend (though this needs to be monitored given the onset of summer and the effect of the recent hailstorms and El Nino on fruit and vegetable prices) and hence the rate hike expectation from RBI has diminished. The much worried US Federal Reserve’s tapering has turned out to be a non-event for the Indian markets and foreign institutional investors’ flows in Indian debt have turned net positive—March has seen strong inflows of around Rs.9,900 crore. Further, after a long period, we believe that we are witnessing corporate credit risk being priced properly, especially since mid-July 2013.

What lies ahead

As a fund house, we are cautiously positive on credit. We feel the probability of improvement in the credit cycle is higher than the probability of deterioration. This belief is predicated on our expectation that interest rates may start to move lower. There might still be short-term accounting pain in terms of the NPA ratios of banks increasing, particularly the state-run banks. But the chance of a negative surprise in terms of an account going bad unexpectedly is relatively low. Real estate is a sector where we believe that there is a likelihood of more stress ahead and therefore this is an exception to our above statement. Our positive view is moderated from the fact that Indian interest rates, despite the recent reductions, continue to be high. Tighter liquidity and higher interest rate may harm prospects of a credit recovery soon. Muted economic growth and impending elections have added to the uncertainty in both borrowing and lending. Our credit view would turn negative if the election throws up a government which is unable to inspire confidence in the country’s economic outlook. A continued slowdown would affect companies which are already on the edge and erode confidence in credit markets further. Similarly expectations of a sustained high interest rate period could be bad for credit markets.